Types of Fraud
While there are many types of fraud, the most common fraud schemes that organizations must prevent include employee embezzlement, vendor fraud, customer fraud and financial statement fraud. Of these four types, employee embezzlement is the most common type of fraud. Employee embezzlement is the process where employees intentionally deceive their employers and take company assets. Examples of employee embezzlement include company workers who intentionally take cash, inventory, tools or other supplies from the organization.Vendor fraud , on the other hand, is the process by which vendors, or suppliers, take advantage of the firm. Vendor fraud often results in an overcharge for purchased goods, the shipment of inferior goods or the nonshipment of goods even though payment has been made. The United States government has often been in the news because major government vendors such as defense and other government contractors have significantly overcharged for goods and services. For example, United States suppliers have been accused of charging more than $20 for a single nail. Often vendor fraud is perpetrated through collusion between buyers and vendors. Once these vendors have overcharged for goods, they will often kickback , or return, a portion of the fraudulent funds to a purchasing agent who represents the organization.
When customer fraud takes place, customers either do not pay for goods purchased or get something for nothing. For example, in one case, a bank customer walked into a branch of a large bank and convinced the branch manager to give her a $525,000 cashier’s check, even though she had only $13,000 in her bank account. The manager believed she was a very wealthy customer and didn’t want to lose her business. Unfortunately for the bank, she proceeded to defraud the bank of over $500,000. Financial Statement Fraud , also often referred to as management fraud , involves situations where company management intentionally makes the company appear more profitable than it actually is.
For example, over the last two decades, management teams at Enron, WorldCom, Parmalat, Adelphia, Waste Management and a number of other companies have intentionally manipulated the financial statements to deceive the public into believing that their respective organizations were more successful than they actually were. These executives engaged in financial statement fraud to increase the company’s stock price, which increased their own net worth (as a result of stock options that each executive possessed). In each of these situations, executives were manipulating the financial statements on behalf of the organization instead of directly stealing from the organization.
Those customers, employees and vendors who engage in fraud are often referred to as fraud perpetrators. Unfortunately, research suggests that anyone can commit fraud and become a fraud perpetrator. In fact, most fraud perpetrators are good people who, because of a series of bad decisions, find themselves engaging in fraudulent behavior.
In one situation, for example, a woman named Suzzyiv had worked for National Security Bank for 34 years and was an honest and trusted employee. Prior to her retirement, however, her granddaughter was born and Suzzy became addicted to the home shopping network where she would buy countless gifts for her new granddaughter. In just three years time, Suzzy embezzled over $600,000 from the bank to support this addictive habit. When the bank discovered the fraud, the bank took possession of Suzzy’s home and retirement account. Her husband, who had no knowledge of the fraud, voluntarily contributed the proceeds of his retirement account to the bank as well.
The bank took possession of virtually every asset the couple owned. In addition, Suzzy still owes the bank over $200,000 and has entered into a restitution agreement to pay the bank that money as well. Suzzy was convicted and incarcerated for one year. All of Suzzy’s friends and family members, including her children, know that she is a convicted felon. When Suzzy was released from prison, she was ordered by the judge to seek active employment so she could start making restitution payments. If she fails to make the payments, she violates her parole agreement and must return to jail. Because of the laws governing banks, the bank was required to submit a criminal referral form to the Office of the Controller of the Currency (OCC) who, by law, was required to submit a copy of the referral to the FBI and the IRS. Because Suzzy did not pay any taxes on any of the stolen funds, the IRS levied fines, penalties, interest, and back taxes on Suzzy. Finally, after all of Suzzy’s suffering, including nearly a year in jail, Suzzy’s husband informed her that he could not handle the situation anymore and that he was filing for a divorce.
As can be seen in the previous example, when fraud occurs everyone loses. The fraud perpetrator suffers humiliation, financial consequences, possible jail time and job loss. The victim organization suffers negative publicity, lower employee moral, and a decrease in financial resources. Researchv suggests that fraud perpetrators can’t be distinguished from other people on the basis of demographic or psychological characteristics. In fact, in order for perpetrators to be successful, they must be able to deceive their victims. As such, most fraud perpetrators have profiles that look like most other honest peoplevi. Fraud perpetrators often have traits that organizations seek for when hiring new employees, seeking out new clients, and selecting vendors. Fraud perpetrators are typically hard-working, well-dressed, easy-to-get along with, professional individuals. Because of this, when fraud does occur, the most common reaction by those around the fraud is denial as victims cannot believe that trusted colleagues have been dishonest.
All frauds include the following elements: 1) A perceived pressure, 2) A perceived opportunity, and 3) Some way to rationalize the fraud as acceptable. These three elements are often referred to as the fraud triangle .
Figure 12-1: Fraud Triangle
Every fraud perpetrator faces some kind of perceived pressure. Most pressures typically involve a financial need, although nonfinancial pressures, such as the need to report financial results better than actual performance, frustration with work, or even a challenge to beat the system can also motivate fraud.
Common financial pressures that victims face include greed, living beyond one’s means, high bills, personal debt, poor credit, personal financial losses and unexpected financial needs. Each of these pressures has been associated with numerous frauds. Often, fraud perpetrators live lifestyles far beyond that of their peers. For example, when one perpetrator was caught stealing $1.3 million from his employer, it was discovered that he had spent the money on monogrammed shirts and gold cuff links, two Mercedes-Benz vehicles, an expensive suburban home, a beachfront condominium, furs, rings, and other jewelry for his wife, a new car for his father-in-law, and a country club membership. Financial pressures can occur suddenly or be long term. The fact that an employee has been an “honest” employee for a long time seems to make no difference when severe financial pressures occur or an individual perceives that such pressures exists.
Closely related to financial pressures are motivations created by vices such as gambling, drugs, alcohol, and expensive extramarital relationships. Vices are the worst kinds of pressures to commit fraud. Examples include female employees who embezzled because their children were on drugs and they couldn’t stand to see them go through withdrawal pains and “successful” managers who, in addition to embezzling from their companies, burglarized homes and engaged in other types of theft to support their drug habits. Finally, work related pressures often influence individuals to engage in fraud. These work related pressures include getting little recognition for job performance, having a feeling of job dissatisfaction, the fear of losing one’s job, being overlooked for a job promotion, and feeling underpaid.
A perceived opportunity to commit fraud, conceal it, and avoid being punished is the second element of the fraud triangle. If fraud perpetrators don’t have an opportunity to commit fraud then fraud will never occur. Fraud often occurs because company management will allow one individual to have too much authorization over one function of the organization (in the form of writing checks, authorizing accounts, and/or providing access to sensitive company information). Organizations can decrease opportunities for fraud by creating an effective internal audit department, conducting control activities, engaging in segregation of duties and consistently using a system of authorization.
An internal audit department is a formal organizational department with the responsibility to audit various divisions of the organization. While internal auditors only discover about one fourth of all frauds (most frauds are discovered through tips, alert employees, or by accident), the presence of internal auditors provides a significant deterrent effect. Internal auditors also provide independent checks and cause perpetrators to question whether they can commit fraud and not be caught.
Another way that organizations can limit their susceptibility to fraud is to periodically perform a series of control activities. Control activities , or procedures, includes the process of routinely checking for errors in any area of the organization. Routinely inspecting the accounts payable ledger, indicating who has been paid over the last few weeks, would be a good example of a control activity. An individual who owns his or her own business and is the sole employee probably does not need many control procedures since he or she would have no incentive to engage in fraud. An owner wouldn’t steal from him or herself, and an owner would never want to treat customers poorly. However, organizations that involve many employees must have control procedures so that the actions of employees will be congruent with the goals of management and the organization. Furthermore, with control activities, opportunities to commit and/or conceal frauds are eliminated or minimized. Good fraud detection and prevention efforts involve matching the most effective control activities with the various risks of fraud.
Segregation of duties involves dividing a task into two parts so that one person does not have complete control of the task. This form of control, like most preventive controls, is most often used when cash is involved. For example, when cash is received by an organization, one employee should record the cash and another employee should handle the cash. If one person did both jobs, then the employee could easily steal the cash and then record that a refund was given to a customer. However, when two employees perform these functions, such fraudulent activity is minimized.
A proper system of authorization ensures that only authorized personnel have access to sensitive company information. For example, computer passwords should be used on all company computers. Furthermore, signature cards and other protective devices should be required to access safe deposit boxes, to cash checks, and to perform other functions at financial institutions. Spending limits should also be placed on all employees so that employees are only able to spend what is in their approved budget.